Ref.: D6.1/ Luxembourg, 11 September 2006 Re: TARGET2-Securities - Market Consultation

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1 European Central Bank Mr. Jean-Michel Godeffroy By Cebamail Ref.: D6.1/ Luxembourg, 11 September 2006 Re: TARGET2-Securities - Market Consultation Dear Jean-Michel, In relation to the market consultation on TARGET2-Securities, as described in the document TARGET2 Securities: Initial Assumptions and Questions (PSSC/2006/352), please find enclosed the reply of the Luxembourg market participants as summarised by BCL. Besides questions of the questionnaire, Luxembourg market participants have also provided comments on competition issues, which we have included in the enclosed documents. Please note also, that the Luxembourg ICSD CBL has provided its views in a consolidated response of the Deutsche Börse Group (DBAG), which has already been provided to the ECB. We have nevertheless inserted the relevant responses to the specific CSD-questions of the questionnaire and are enclosing the DBAG group response to this letter. Sincerely Yours, Pierre Thissen Conseiller de direction adjoint Pierre Beck Chef du département Systèmes de paiement Encl.: CC:./.

2 The comments or the views of the Luxembourg market participants are highlighted in grey. A) Comments of Luxembourg market participants on issues that are not explicitly asked in the questionnaire Participation in TARGET2: It was asked whether it would be mandatory to be participant in TARGET2 in order to participate in T2S. There are banks with a payment volume not sufficient for a participation in TARGET2, but which could have a sufficient activity in securities to desire a more efficient settlement through T2S. B: Comments of Luxembourg market participants on initial assumptions on T2S: Initial assumptions on TARGET2-Securities scope of services Market participants are invited to express whether the assumptions below are in line with their expectations and are encouraged to present alternatives. No parallel settlement with CSDs: Once T2S is fully deployed, no division of settlement activity is expected between T2S and CSDs: neither in time (day/night) nor by type of asset (debt/equities). Gradual deployment: The T2S will probably be implemented in a phased manner. In this respect, we interpret the market s priority to be the daylight DVP1 settlement of debt securities. Settlement frequency: Real-time settlement with optimisation mechanisms will be offered (DVP model 1 and FoP). The business case for offering batch settlement will be investigated. Self-collateralisation facilities will be offered. Nature of participation: Service offered to CSDs (directly) and their participants (indirectly). User Committees: User committees will be established to ensure the involvement of CSDs and their participants. Cost and pricing: Investment and running costs to be covered by fees. T2S would make no pricing distinctions between what are now domestic and cross-border transactions. Fees would be levied on the participating CSDs on the basis of a published fee schedule. CSDs would apply their own fee schedule to their customers. This should translate for end-users in 2

3 lower prices for the sole DVP settlement service in central bank money, thanks to the economies of scale allowed by the recourse to T2S for the provision of that service. C) Comments of Luxembourg market participants on the questionnaire: Questions to market participants Market participants are invited to provide their views on the open questions below and raise any further questions they might have. Scope of assets and services - Do you agree TARGET2-Securities should cover the settlement in central bank money of all debt instruments and equities in euro? Or would you prefer CSD platforms to continue to offer settlement of securities in central bank money for some assets (e.g. non-eligible assets for Eurosystem credit operations; batch settlement)? In general terms, the Luxembourg market participants support a comprehensive approach, i.e. they favour the idea of T2S settling all types of securities, including equities. Because of the overall complexity of the project and the number of parties involved, concerns were raised that as a result of T2S, costs of settling equities might increase for the participants. - Would you expect T2S to cover also the settlement of euro bonds? The consulted participants supported the idea that the settlement of Eurobonds in central bank money should be offered as an option. They point however to the fact that there is at present hardly any restriction to the access of Eurobonds. If Eurobonds in euros were to be settled exclusively in central bank money, this could change the market and reduce its attractiveness for non euro area banks, investors and issuers. Furthermore a significant part of the Eurobonds is issued in currencies other than the euro and could therefore not be settled in T2S. All in all there was the feeling that there is currently not enough information available on T2S to analyse the issue of Eurobonds in sufficient detail. - Is it absolutely necessary to complement the T2S service with other CSD services (e.g. collateral management services; securities lending services) or can the provision of these services remain at the CSD level (CSDs could be considered as users of T2S for these services)? 3

4 Luxembourg market participants expressed the view that the mentioned services need to be available at the level of T2S. At the same time, they also acknowledge that the provision of these services in the T2S environment require the involvement of the CSDs and hence a very close cooperation with the connected CSDs. - On the assumption that equities will settle in T2S, is there a business case for equities (or other assets) to settle in real-time (DVP1 with optimisation mechanisms)? Or should also the possibility to settle in batches be provided? Luxembourg market participants had two remarks in this respect: for most of the transactions, batch processing would be appropriate, there should however be a sufficient frequency of batches; for some particular transactions (collateral or back to back transactions for instance), time is critical and therefore there is a need to have also real time settlement available. - Do you believe T2S should offer facilities for matching and release/blockage of instructions? For certain securities, should T2S have a connection with another platform (e.g. trading platforms) which would do the matching? Luxembourg market participants clearly stated the need for matching, be it at the level of T2S or at the level of their CSD. Where matching occurs, depends on the connection of banks to T2S. If the technical connection between the bank and T2S is a direct one, it would be actually very difficult for the CSD to continue offering matching services. It is only if the CSD intermediates in the connection, that it could offer matching services. Cross-system matching should in any case involve T2S. - Should T2S offer the same opening times as TARGET2? Luxembourg market participants had various remarks: It is assumed that the TARGET2 opening times include the foreseen night-time window for securities settlement. In order to stick to the present functioning of the European capital markets and to provide first cash positions at 7 o clock to prepare the settlement of CLS, the bulk of the securities transactions need to be settled overnight. At the end of the day, there should be a window in which only TARGET2 operates to enable treasurers to square their cash positions at the end of the day. Stock exchanges and CCPs - What specific issues are relevant for CCPs as participants in CSDs which are on the T2S platform? There is no CCP in Luxembourg. 4

5 - What specific issues are relevant for stock exchanges and trading platforms which either clear via a CCP or directly settle in a CSD? There is no CCP in Luxembourg. Stock exchange transactions on the Luxembourg Stock Exchange are not automatically forwarded to a specific clearing and settlement partner. It is up to the two contracting parties to agree on clearing and settlement details. This might change in future as the Luxembourg Stock Exchange has recently signed a cooperation agreement with Euronext and will use the Euronext trading platform. The clearing and settlement procedures might be affected following the implementation of this trading platform. Furthermore the Luxembourg Stock Exchange has a significant trading volume denominated in currencies other than the Euro and regrets that T2-Securities will not support that part of their business. Finally the Luxembourg Stock Exchange also regretted that the direct access to T2S was restricted to CSDs. In their view, other players, notably stock exchanges could also be granted access if this supported their customers. The data and communication flow would have to be coordinated with CSDs to guarantee interoperability. Non- settlement in the euro area and settlement outside the euro area - Does your CSD offer settlement services in currencies other than? If yes, what is the relative weight of these securities (in relation to total custody and total settlement volumes)? What type of securities are they and in which currencies are they denominated? What could be the alternative for these non- denominated securities once a CSD joins T2S (knowing that T2S will operate only in )? CBL indeed offers settlement services in 40 currencies other than the. They represent approximately one third of the total custody and approximately on fifth of the settlement volume 1. It is assumed that CBL could go on offering these settlement services, even if denominated securities held in CBL can be settled in central bank money. - What could be the solution for denominated securities settled in non-euro area CSDs? To include -denominated securities settled in non-euro area CSDs in T2S, the respective CSDs would have to be connected to T2S and their participants would need an efficient access to central bank money in. Account structure - For T2S to offer cross-border settlement which of the following basic options (or which combination of options) do you deem more feasible: 1 Excluding new issues, redemptions and securities lending 5

6 (a) users who wish to be able to settle a given type of asset open a securities account in the CSD issuing that asset; (b) CSDs participating in T2S open reciprocal accounts (links), so that users need only maintain an account with their local CSD?; (c) users settling assets issued in a CSD where they do not have a securities account designate a local custodian Luxembourg market participants made the following comments: Option a) [account in issuer SSS] is not considered feasible because it is too cumbersome and not required. The need for links (option b) seems obvious, although there were doubts concerning the ability of all CSDs to offer complex multi-country custody services. Furthermore banks often have a preference for using local custodians. It was indeed stated that the handling of corporate actions becomes more and more difficult, all the more because of the increased complexity of the underlying assets and the diverging fiscal regulations. - What is the most feasible securities account structure in T2S? To what extent are subaccounts for wholesale customers (to omnibus accounts of participants) needed for the monitoring and efficient processing (transmission of instructions) of wholesale customers transactions? In countries where a direct holding structure is in place, what would be the optimal level of aggregation? Luxembourg market participants state that the need to establish sub-accounts for wholesale customers depends on the respective market rules and national legislations (e.g. fiscal constraints), which is in their view more relevant than pure operational considerations. - As a potential user of T2S, would you prefer the payments associated to securities transactions to be credited / debited (a) directly on your TARGET2 RTGS account/special purpose TARGET2 RTGS account with the usage of all TARGET2 control and monitoring tools (ICM), (b) on a dedicated account within T2S (linked to the RTGS account) possibly with the usage of ICM tools? Luxembourg market participants expressed a unanimous preference for dedicated cash accounts within T2S, which should be accessible through the ICM. Corporate actions - Let us assume T2S settles continuously (i.e. day and night) and after the end-of-day securities are repatriated to the issuing CSD. How much time do you believe is needed 6

7 by the issuers, the paying agents and the CSD to conduct their functions (custody, corporate events )? Is there a specific period during which these functions must be performed? During the processing of corporate events on a given security, the CSD blocks the securities and prevents settlement of transactions of the specific security in order to prevent a change in the account balances. The processing of corporate actions should therefore take place during the night. Given the importance of the processing of corporate actions, Luxembourg market participants favour a thorough analysis of this item in order to ensure that no disruption would occur in the market as compared to today s practices. CBL: The processing of elective Corporate events will require intraday real-time position updates, as will securities financing and collateral management. - Which corporate events are processed on the basis of an intraday position (i.e. knowledge by the CSD of the end-of-day position is not sufficient)? What would be the requirements of CSDs for processing corporate events intraday? CBL: Information is required on an ongoing basis in order to provide timely information on both future and ongoing income and Corporate events, as well as timely updates. Some impacted categories of elective corporate events: Exdate events where rights are generated eg. o Choice dividends o Subscription offers Non-Exdate events where the securities must be blocked or surrendered o Exchanges o Put options o Meetings/ votes Communication - What are your preferences in terms of communication protocols and communication network? For the Luxembourg market participants SWIFT is the market standard for communication, nearly all Luxembourg based banks are connected to the SWIFT network. SWIFT format 7

8 should be used, but for the communication between the CSD (as message transmitter) and T2S, a more cost efficient network could be chosen. - What role should CSDs play in the routing of settlement instruction to T2S? Luxembourg market participants would see the CSDs as a pure transmitter of messages, however, in more complex transactions involving collateralisation or securities lending, CSDs would have to be directly involved. - For CSDs: What are your preferences in terms of communication with regard to the mirroring of accounts at the beginning and the end of the day? Is there a need for realtime communication during the day between CSDs and T2S? CBL: There is a clear need for real time communication between CSDs and T2S to perform position keeping allowing corporate action notification and processing and equally importantly securities lending and collateral management services. - What information would CSD participants wish to have available from T2S (a) throughout the working day on a real-time basis; (b) at the end of the day? Luxembourg market participants would wish to have on an online basis the usual information concerning clearing and settlement, i.e. status of the introduced transactions (matched/unmatched, settled/failed, etc.) as well as their securities position. This information would be accessible from T2S in case of a direct communication of the banks with T2S or from the CSD in case the communication is via the CSDs. Timing / Priorities - What timeframe would you consider realistic for the Eurosystem to launch TARGET2- Securities (considering the difficulties you expect will be encountered)? Luxembourg market participants did not have a strong view on this point, however, assuming that a decision is taken in 2007, a launch by 2012 / 2014 is considered to be realistic. In their view it is also important that a clear and stable decision is taken in the upcoming year to allow them to analyse the various impacts on them and to prepare themselves effectively for the new environment. Given the cost impact incurred by banks in this activity, a deadline as well as milestones should be clearly explained to market participants so that they have enough time for analysis and preparation (including at least implementation of new routing procedures, training staff, reviewing current agreements, etc.). - Do you see any problem in a phased implementation (e.g. certain services to start earlier than others or a phased country migration)? 8

9 Luxembourg market participants did not identify at this juncture which is still characterised by great uncertainties any impediment to a phased implementation. All this would require a thorough analysis, once a final decision concerning the system itself has been taken. Impact on CSDs (only for CSDs to answer) What are the incentives / disincentives for CSDs to join T2S? CBL: We appreciate that T2S could result in a level playing field for access to central bank money liquidity for all CSDs. Furthermore, T2S could be the nucleus for opening up a fragmented landscape to competition. We consider the combination of both as a base for ongoing product and service innovation, increasing the competitiveness and attractiveness of European capital markets. We still need to better understand how T2S would change the business dynamics. The extent will be determined by the scope of T2S which is currently subject to many open questions, and many potential issues. A key incentive would be if the end-to end costs to participants can be reduced, and innovation made faster and cheaper. If there are liquidity splits reducing market efficiency, high-investment requirements, high uncertainty, and reduced economies of scale these will be disincentives. - What is the amortisation period of the settlement platform currently used by your CSD? What about the investment cycle? Has your CSD initiated further investments to improve the current platform? Have investments been made to build a future platform? By when will these investments be amortised and at what rate? CBL: We implement service and product developments to further improve the efficiency of the market on an ongoing investment cycle. T2S implies that both amortised and ongoing investments would have to be adapted to T2S, requiring additional investments. If there is an investment freeze in the interim period leading up to T2S, there is a likelihood that the resource capacity will shift to other responsibilities, compromising the ability to adapt to T2S. - What would be the cost savings for CSDs in joining T2S and not having to develop a settlement platform themselves? The scope and impact of T2S and the requirements to perform the Custody functions will determine the degree to which investments are required for T2S, and any potential long term 9

10 savings. There will be no cost savings unless there is a decommissioning of services and infrastructure at the CSD. - How would T2S affect the links among CSDs of the euro area? How about the links with CSDs outside the euro area. CBL: T2S would make obsolete most existing CSD links for settlement purposes. As most of the existing links are not efficient due to their limitation to FOP settlement, we consider this a clear improvement of CSD interoperability. However, CSD links will still be required, as the notary function and custody remain with the issuer CSD, in particular in case of account structure option (b). Links to CSDs outside the euro area are not addressed by T2S and need to be maintained independently. Potential obstacles - What are the main obstacles you see for this project to materialise? Luxembourg market participants see as main obstacles uncertainties regarding the costs of clearing and settlement, and co-existence of different settlement systems / too much complexity in the settlement landscape. As concerns cost-savings, it is felt that at least during a certain phase there would be an increase in costs, since the users would have to pay the platform and the services. In a more optimistic scenario, it might be possible that there are at some stage cost savings for the market as a whole, but not necessarily for each individual bank. For the system to be attractive, the end-to-end cost of the participants needs to be reduced. Legal/regulatory issues: the law applicable to the system is a key issue at least regarding important aspects like settlement finality or anti money laundering. Moreover, for countries with banking secrecy, the transfer of securities in T2S and the whole setup need to be compliant with the banking secrecy legislation. uncertainty about-recoverability of investment costs: assuming that there are various unknown future evolutions (e.g. development of alternative /competing systems, insufficient participation to T2S, destruction of T2S by disaster events) it might be possible that T2S would have to be closed down temporarily or definitively. For these cases, it needs to be clear from the outset who would bear the investment costs (i.e. who carries the project risk?) systemic risk issues would have to be addressed (increased systemic risk since consolidation to one big platform), what alternatives would be available in case of systemic risk and disaster events? 10

11 potential competition issue and efficiency: Privileged position of (I)CSDs and efficiency of T2S: if only (I)CSDs can directly join T2S, it should be guaranteed to participant banks or users that costs will remain under control. The participation structure envisaged so far would give (I)CSDs a quasi-monopolistic position. Thus, T2S should not be a compulsory infrastructure, but a mechanism that would complement the existing infrastructures. Users should use T2S because of cost, efficiency, and safety reasons and not because there is no other choice. T2S should permit a reduction of fees. If T2S is not compulsory, there will be a continuous pressure on T2S to perform the state of art in settlement and services at costs being competitive versus other alternatives. Without competition between T2S and alternative systems, services of T2S might not be as efficient and costs not be as low for users than they would be in a competitive environment, in the medium and long term. potential competition issue: the set up envisaged currently might favour (I)CSDS to the detriment of banks. T2S would bring (I)CSDs in a stronger position (since they have the access) for the provision of custody activity as well as other services (lending, collateralisation, etc). A level playing field would require that T2S creates no distortion in competition between (I)CSDs and custodian banks. - Do you see any problem in separating the platform that provides settlement services (T2S) from the custody and other services that will remain to be provided by the CSDs? Would you identify any legal obstacles in your country that would have to be removed for T2S to provide instantaneous finality? Luxembourg market participants feel that for securities lending activities and collateral management (self and auto-collateralisation), there should be a closer link between T2S and (I)CSDs. The issue of finality should be more investigated with regards of direct participation of banks to T2S or indirect participation of banks to T2S via a CSD. - Do you see any internal constraints (organizational, technical or financial) which could hamper the connection of your institution to T2S? Luxembourg market participants referred to the issue of cash accounts in TARGET2. According to their view a bank should not need to have an account in TARGET2, as long as dedicated cash accounts in T2S are used. - What prerequisites would you point out in terms of harmonisation? 11

12 Luxembourg market participants feel that cross border settlement would require further progress in the removal of the Giovannini barriers, in particular barrier 1, 3, 7 and 8. 12